Financial Statements Still Significant In Predicting Bankruptcy

Researchers have found that financial ratios are still valuable tools in predicting bankruptcy. The significance of financial ratios found in statements was explored in a study examining their predictive value over the last four decades, according to the Stanford Graduate School of Business (GSB).

The GSB reported that the premise of the study was motivated by regulatory organizations, such as the Financial Accounting Standards Board and the Securities and Exchange Commission, seeking to increase the usefulness of information found in financial statements.

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The study, completed by Professors Maureen McNichols and William Beaver, with graduate student Jung-Wu Rhie, reexamined the use of financial ratios such as cash flow to total liabilities (earnings before interest, depreciation, and taxes divided by short-term debt plus long-term debt), return on assets (net income divided by total assets), leverage (total liabilities compared to total assets), according to the GSB.

McNichols is the Marriner S. Eccles Professor of Public and Private Management at the GSB. Beaver is the Joan E. Horngren Professor of Accounting there.

McNichols told the GSB, “One prediction is that if standard-setters are successful at incorporating additional information about fair values into financial statements, then we might expect their predictive ability for bankruptcy to increase.”

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On the other hand, traditional accounting standards may capture only a portion of current companies’ scope of activities. Also, financial statements may be seen as more “managed” than from other times in the past, according to the GSB.

“If we look back in the 1960s, intangible assets -– as represented by investments in brands, research and development and technology -– were much less pervasive than they are today. These kinds of transactions are not well captured by our current accounting model,” Professor McNichols told the GSB. Concerning the “management” of financial statements, McNichols said, “Certainly, there is much more documentation of earnings management today than we’ve seen historically.”

McNichols went on to say that any shift in the economic activities of companies might also offset any improvements in standards and informativeness of financial statements made by regulatory standard-setters, according to the GSB.

In study results released in March 2005, financial statements were found to be highly significant in predicting bankruptcy over the two periods of the study, according to the GSB. Period 1 was 1962 to 1993 and Period 2 was 1994 to 2002. There was a decline in predictive ability from Period 1 to Period 2, although it was not statistically significant. Companies’ “hazard rate”, reflecting their risk of going bankrupt and using the three ratios, predicted higher risk in the year before bankruptcy, as well as other years before their insolvency. Beaver said, “In fact, we see differences in the ratios of bankrupt and nonbankrupt firms up to five years prior to bankruptcy.”

The researchers then shifted their predictors toward more market-based values. These were cumulative stock returns over a year; the market capitalization of the firm (or common stock price per share, times the common shares outstanding); and the variability of stock returns. The use of these values was very predictive as well, according to the GSB.

Predictability actually increased over time. Ninety-two percent of bankrupt companies were in the highest three deciles of Period 1 hazard rates and 93 percent for Period 2. The slight rise was attributed to market prices reflecting broader information, in addition to the information found in financial statements. The GSB reported that the incremental significance of non-financial statement information is reflected in the resulting difference between the two time periods.

The researchers then merged the financial-ratio and market-based models into a hybrid model. Their results improved, coming up with a 96 percent chance of predicting bankruptcy for Period 1 and 93 percent over Period 2. This seems to show that market prices may compensate for even slight decreases in the predictivity of financial ratios. These results further indicate that the market draws upon additional information not available in financial ratios.

McNichols told the GSB, “But it’s comforting to know that the behavior of the combined model, over time, is so stable.” The stability of their combined model suggests that bankruptcy can be predicted reliably in capital markets and this ability has not been eroded by changes in reporting.

Dr. Edward Altman, Ph.D., developed his Z-score formula for predicting bankruptcy in 1968, according to Value Based Management. It consists of three different models, each for specific business organizations, including public manufacturers, private manufacturers and private general firms.

The American Bankruptcy Institute collects and publishes metrics on bankruptcies. Review their listing of annual business and non-business filings by state (2000-2005) breaks down total bankruptcies into business and non-business numbers, as well as consumer bankruptcies as a percentage of the non-business metrics.